Capital Budgeting

1. 1 Capital Budgeting

2. 2 Capital Budgeting USING THE NET PRESENT VALUE RULE TO MAKE VALUE-CREATING INVESTMENT DECISIONS

3. 3 Background A good investment decision One that raises the current market value of the firm�s equity, thereby creating value for the firm�s owners Capital budgeting involves Comparing the amount of cash spent on an investment today with the cash inflows expected from it in the future Discounting is the mechanism used to account for the time value of money Converts future cash flows into today�s equivalent value called present value or discounted value Apart the timing issue, there is also the issue of the risk associated with future cash flows Since there is always some probability that the cash flows realized in the future may not be the expected ones

4. 4 Background After this session, participants should understand: The major steps involved in a capital budgeting decision How to calculate the present value of a stream of future cash flows The net present value (NPV) rule and how to apply it to investment decisions Why a project�s NPV is a measure of the value it creates How to use the NPV rule to choose between projects of different sizes or different useful lives How the flexibility of a project can be described with the help of managerial options

5. 5 The Capital Investment Process Capital investment decision (capital budgeting decision, capital expenditure decision) involves four steps Identification Evaluation Selection Implementation and audit Investment proposals are also often classified according to the difficulty in estimating the key valuation parameters Required investments Replacement investments Expansion investments Diversification investments

6. 6 EXHIBIT 1: The Capital Investment Process.

7. 7 Assessing a Capital Budget Without time value of money Payback period Bailout payback With time value of money Discounted payback Net present value Profitability index Internal rate of return Annuity equivalent cash flow

8. 8 Why The NPV Rule Is A Good Investment Rule The NPV rule is a good investment rule because Measures value creation Reflects the timing of the project�s cash flows Reflects its risk Additive

9. 9 A Measure Of Value-Creation The present value of a project�s expected cash flows stream at its cost of capital Estimate of how much the project would sell for if a market existed for it The net present value of an investment project represents the immediate change in the wealth of the firm�s owners if the project is accepted If positive, the project creates value for the firm�s owners; if negative, it destroys value

10. 10 Adjustment For The Timing Of The Project�s Cash Flows NPV rule takes into consideration the timing of the expected future cash flows Demonstrated by comparing two mutually exclusive investments with the same initial cash outlay and the same cumulated expected cash flows But with different cash flow profiles Exhibit 2 describes the two investments Exhibit 3 shows the computation of the two investments� net present values

11. 11 EXHIBIT 2: Cash Flows for Two Investments with CF0 = $1 Million and k = 0.10.

12. 12 EXHIBIT 3: Present Values of Cash Flows for Two Investments.Figures from Exhibit 2

13. 13 Adjustment For The Risk Of The Project�s Cash Flows Risk adjustment is made through the project�s discount rate Because investors are risk averse, they will require a higher return from riskier investments As a result, a project�s opportunity cost of capital will increase as the risk of the investment increases By discounting the project� cash flows at a higher rate, the project�s net present value will decrease

14. 14 EXHIBIT 4: Cash Flows for Two Investments with CF0 = $1 Million, k = 0.12 for Investment C, and k = 0.15 for Investment D.

15. 15 EXHIBIT 4a: Present Values of Cash Flows for Two Investments.Figures from Exhibit 4

16. 16 EXHIBIT 4b: Present Values of Cash Flows for Two Investments.Figures from Exhibit 1.3

17. 17 Additive Property If one project has an NPV of $100,000 and another an NPV of $50,000 The two projects have a combined NPV of $150,000 Assuming that the two projects are independent Additive property has some useful implications Makes it easier to estimate the impact on the net present value of a project of changes in its expected cash flows, or in its cost of capital (risk) An investment�s positive NPV is a measure of value creation to the firm�s owners only if the project proceeds according to the budgeted figures Consequently, from the managers� perspective, a project�s positive NPV is the maximum present value that they can afford to �lose� on the project and still earn the project�s cost of capital

18. 18 Special Cases Of Capital Budgeting Comparing projects with unequal sizes If there is a limit on the total capital available for investment Firm cannot simply select the project(s) with the highest NPV Must first find out the combination of investments with the highest present value of future cash flows per dollar of initial cash outlay Can be done using the projects� profitability index

19. 19 Special Cases Of Capital Budgeting Firm should first rank the projects in decreasing order of their profitability indexes Then select projects with the highest profitability index Until it has allocated the total amount of funds at its disposal However, the profitability index rule may not be reliable When choosing among mutually exclusive investments When capital rationing extends beyond the first year of the project

20. 20 EXHIBIT 5: Cash Flows, Present Values, and Net Present Values for Three Investments of Unequal Size with k= 0.10.

21. 21 EXHIBIT 6: Profitability Indexes for Three Investments of Unequal Size.Figures from Exhibit 6.12

22. 22 Special Cases Of Capital Budgeting Comparing projects with unequal life spans If projects have unequal lives Comparison should be made between sequences of projects such that all sequences have the same duration In many instances, the calculations may be tedious Possible to convert each project�s stream of cash flows into an equivalent stream of equal annual cash flows with the same present value as the total cash flow stream Called the constant annual-equivalent cash flow or annuity-equivalent cash flow Then, simply compare the size of the annuities

23. 23 EXHIBIT 7a: Cash Outflows and Present Values of Cost for Two Investments with Unequal Life Spans.

24. 24 EXHIBIT 7b: Cash Outflows and Present Values of Cost for Two Investments with Unequal Life Spans.

25. 25 EXHIBIT 8:Original and Annuity-Equivalent Cash Flows for Two Investments with Unequal Life Spans.Figures from Exhibit 6.14 and Appendix 6.1

26. 26 Limitations Of The Net Present Value Criterion Although the net present value criterion can be adjusted for some situations It ignores the opportunities to make changes to projects as time passes and more information becomes available NPV rule is a take-it-or-live-it rule A project that can adjust easily and at a low cost to significant changes such as Marketability of the product Selling price Risk of obsolescence Manufacturing technology Economic, regulatory, and tax environments Will contribute more to the value of the firm than indicated by its NPV Will be more valuable than an alternative project with the same NPV, but which cannot be altered as easily and as cheaply A project�s flexibility is usually described by managerial options

27. 27 Managerial Options Embedded In Investment Projects The option to switch technologies Discussed using the designer desk lamp project of Sunlight Manufacturing Company (SMC) as an illustration The option to abandon a project Can affect its net present value Demonstrated using an extended version of the designer-desk lamp project Although the project was planned to last for five years, we assume now that SMC�s management will always have the option to abandon the project at an earlier date Depending on if the project is a success or a failure

28. 28 Dealing With Managerial Options Above options are not the only managerial options embedded in investment projects Option to expand Option to defer a project Managerial options are either worthless or have a positive value Thus, NPV of a project will always underestimate the value of an investment project The larger the number of options embedded in a project and the higher the probability that the value of the project is sensitive to changing circumstances The greater the value of those options and the higher the value of the investment project itself

29. 29 Dealing With Managerial Options Valuing managerial options is a very difficult task Managers should at least conduct a sensitivity analysis to identify the most salient options embedded in a project, try at valuing them and then exercise sound judgment

30. 30 EXHIBIT 10: Steps Involved in Applying the Net Present Value Rule.

31. 31 Capital Budgeting ALTERNATIVES TO THE NPV RULE

32. 32 Background We will examine four alternatives to the NPV method Ordinary payback period Discounted payback period Internal rate of return Profitability index You should understand The four alternatives to NPV method and how to calculate them How to apply the alternative rules to screen investment proposals Major shortcomings of the alternative rules Why these rules are still used even though they are not as reliable to the NPV rule

33. 33 Conditions of a Good Investment Decision Does it adjust for the timing of the cash flows? Does it take risk into consideration? Does it maximize the firm�s equity value?

34. 34 The Payback Period A project�s payback period is the number of periods required for the sum of the project�s cash flows to equal its initial cash outlay Usually measured in years

35. 35 The Payback Period Rule According to this rule, a project is acceptable if its payback period is shorter than or equal to the cutoff period For mutually exclusive projects, the one with the shortest payback period should be accepted

36. 36 Does the payback period rule meet the conditions of a good investment decision? Adjustment for the timing of cash flows? Ignores the time value of money Adjustment for risk? Ignores risk Maximization of the firm�s equity value? No objective reason to believe that there exists a particular cutoff period that is consistent with the maximization of the market value of the firm�s equity The choice of a cutoff period is always arbitrary The rule is biased against long-term projects

37. 37 Why Do Managers Use The Payback Period Rule? Payback period rule is used by many managers Often in addition to other approaches Redeeming qualities of this rule Simple and easy to apply for small, repetitive investments Favors projects that �pay back quickly� Thus, contribute to the firm�s overall liquidity Can be particularly important for small firms Makes sense to apply the payback period rule to two investments that have the same NPV Because it favors short-term investments, the rule is often employed when future events are difficult to quantify Such as for projects subject to political risk

38. 38 The Discounted Payback Period The discounted payback period, or economic payback period Number of periods required for the sum of the present values of the project�s expected cash flows to equal its initial cash outlay Compared to ordinary payback periods Discounted payback periods are longer May result in a different project ranking

39. 39 The Discounted Payback Period Rule The discounted payback period rule says that a project is acceptable If discounted payback period is shorter or equal to the cutoff period Among several projects, the one with the shortest period should be accepted

40. 40 Does the discounted payback period rule meet the conditions of a good investment decision? Adjustment for the timing of cash flows? The rule considers the time value of money Adjustment for risk? The rule considers risk Maximization of the firm�s equity value? If a project�s discounted payback period is shorter than the cutoff period Project�s NPV when estimated with cash flows up to the cutoff period is always positive The rule is biased against long-term projects The discounted payback period rule cannot discriminate between the two investments

41. 41 The Discounted Payback Period Rule Vs. The Ordinary Payback Period Rule The discounted payback period rule is superior to the ordinary payback period rule Considers the time value of money Considers the risk of the investment�s expected cash flows However, the discounted payback period rule is more difficult to apply Requires the same inputs as the NPV rule Used less than the ordinary payback period rule

42. 42 The Internal Rate Of Return (IRR) A project's internal rate of return (IRR) is the discount rate that makes the net present value (NPV) of the project equal to zero An investment�s IRR summarizes its expected cash flow stream with a single rate of return that is called internal Because it only considers the expected cash flows related to the investment Does not depend on rates that can be earned on alternative investments

43. 43 The IRR Rule A project should be accepted if its IRR is higher than its cost of capital and rejected if it is lower If a project�s IRR is lower than its cost of capital, the project does not earn its cost of capital and should be rejected

44. 44 Does the IRR rule meet the conditions of a good investment decision? Adjustment for the timing of cash flows? Considers the time value of money Adjustment for risk? The rule takes risk into consideration The risk of an investment does not enter into the computation of its IRR, but the IRR rule does consider the risk of the investment because it compares the project�s IRR with the minimum required rate of return--a measure of the risk of the investment

45. 45 The IRR Rule May Be Unreliable The IRR rule may lead to an incorrect investment decision when Two mutually exclusive projects are considered A project�s cash flow stream changes sign more than once

46. 46 Investments With Some Negative Future Cash Flows Negative cash flows can occur when an investment requires the construction of several facilities that are built at different times When negative cash flows occur a project may have multiple IRRs or none at all Firm should ignore the IRR rule and use the NPV rule instead

47. 47 Why Do Managers Usually Prefer The IRR Rule To The NPV Rule? IRR calculation requires only a single input (the cash flow stream) However, applying the IRR rule still requires a second input�the cost of capital When a project�s cost of capital is uncertain, the IRR method may be the answer Most managers find the IRR easier to understand Managers usually have a good understanding of what an investment should "return� Advice: Compute both a project�s IRR and NPV If they agree, use the IRR If they disagree, trust the NPV rule

48. 48 The Profitability Index (PI) The profitability index Benefit-to-cost ratio equal to the ratio of the present value of a project�s expected cash flows to its initial cash outlay

49. 49 The Profitability Index Rule According to the PI rule a project should be accepted if its profitability index is greater than one and rejected if it is less than one

50. 50 Does the PI rule meet the conditions of a good investment decision? Adjustment for the timing of cash flows? Takes into account the time value of money Project�s expected cash flows are discounted at their cost of capital Adjustment for risk? The PI rule considers risk because it uses the cost of capital as the discount rate Maximization of the firm�s equity value? When a project�s PI > 1 the project�s NPV > 0 and vice-versa Thus, it may appear that PI is a substitute for the NPV rule Unfortunately, the PI rule may lead to a faulty decision when applied to mutually exclusive investments with different initial cash outlays

51. 51 Use Of The Profitability Index Rule The PI is a relative measure of an investment�s value NPV is an absolute measure Thus, the PI rule can be a useful substitute for the NPV rule when presenting a project�s benefits per dollar of investment

52. 52 Capital Budgeting IDENTIFYING AND ESTIMATING A PROJECT�S CASH FLOWS

53. 53 Background Fundamental principles guiding the determination of a project�s cash flows and how they should be applied Actual cash-flow principle Cash flows must be measured at the time they actually occur With/without principle Cash flows relevant to an investment decision are only those that change the firm�s overall cash position

54. 54 Background Participants should understand The actual cash-flow principle and the with/without principle and how to apply them when making capital expenditure decisions How to identify a project�s relevant and irrelevant cash flows Sunk costs and opportunity costs How to estimate a project�s relevant cash flows

55. 55 The Actual Cash-flow Principle Cash flows must be measured at the time they actually occur If inflation is expected to affect future prices and costs, nominal cash flows should be estimated Cost of capital must also incorporate the anticipated rate of inflation If the impact of inflation is difficult to determine, real cash flows can be employed Inflation should also be excluded from the cost of capital A project�s expected cash flows must be measured in the same currency

56. 56 The With/Without Principle The relevant cash flows are only those that change the firm�s overall future cash position, as a result of the decision to invest AKA: incremental, or differential, cash flows Equal to difference between firm�s expected cash flows if the investment is made (the firm �with� the project) and its expected cash flows if the investment is not made (the firm �without� the project)

57. 57 Identifying A Project�s Relevant Cash Flows Sunk cost Cost that has already been paid and for which there is no alternative use at the time when the accept/reject decision is being made With/without principle excludes sunk costs from the analysis of an investment Opportunity costs Associated with resources that the firm could use to generate cash, if it does not undertake the project Costs do not involve any movement of cash in or out of the firm

58. 58 Identifying A Project�s Relevant Cash Flows Costs implied by potential sales erosion Another example of an opportunity cost Sales erosion can be caused by the project, or by a competing firm Relevant only if they are directly related to the project If sales erosion is expected to occur anyway, then it should be ignored Allocated costs Irrelevant as long as the firm will have to pay them anyway Only consider increases in overhead cash expenses resulting from the project

59. 59 Estimating A Project�s Relevant Cash Flows The expected cash flows must be estimated over the economic life of the project Not necessarily the same as its accounting life�the period over which the project�s fixed assets are depreciated for reporting purposes

60. 60 Measuring The Cash Flows Generated By A Project Classic formula relating the project�s expected cash flows in period t to its expected contribution to the firm�s operating margin in period t: CFt = EBITt(1-Taxt) + Dept - ?WCRt - Capext Where: CFt = relevant cash flow EBITt = contribution of the project to the Firm�s Earnings Before Interest and Tax Taxt = marginal corporate tax rate applicable to the incremental EBITt Dept = contribution of the project to the firm�s depreciation expenses ?WCRt = contribution of the project to the firm�s working capital requirement Capext = capital expenditures related to the project

61. 61 Estimating the Project�s Initial Cash Outflow Project�s initial cash outflow includes the following items: Cost of the assets acquired to launch the project Set up costs, including shipping and installation costs Additional working capital required over the first year Tax credits provided by the government to induce firms to invest Cash inflows resulting from the sale of existing assets, when the project involves a decision to replace assets, including any taxes related to that sale

62. 62 Estimating The Project�s Intermediate Cash Flows The project�s intermediate cash flows are calculated using the cash flow formula

63. 63 Estimating The Project�s Terminal Cash Flow The incremental cash flow for the last year of any project should include the following items: The last incremental net cash flow the project is expected to generate Recovery of the project�s incremental working capital requirement, if any After-tax resale value of any physical assets acquired in relation to the project Capital expenditure and other costs associated with the termination of the project

64. 64 Sensitivity Analysis Sensitivity analysis is a useful tool when dealing with project uncertainty Helps identify those variables that have the greatest effect on the value of the proposal Shows where more information is needed before a decision can be made